Equity Valuation

Book ValueMarket Value Intrinsic Value

Intrinsic value of the security is the value of its own, which it enjoys due to the fundamentals of the company.

Relationship between Market Value and Intrinsic Value

  Market value > Intrinsic value Stock

is overpriced Market value = Intrinsic value Stock

is correctly priced Market value < Intrinsic value Stock

is underpriced

Dividend Discount ModelP/E Approach

the intrinsic value of a stock is the present value of all the cash flows expected from the stock

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dividends future expected all of luepresent va

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Himanshu wants to buy Abhishek Industires stock and hold on it for five years. He estimates that Rs 4.05 dividend would be paid by the company continuously for the next five years. He hopes to sell the shares at Rs 75 at the end of the fifth year. If his required rate of return is 10%, then what price he should pay at present?

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Using Historical DividendsUsing Historical EarningsUsing Return on equity and payout

ratioG= (1-Payout ration) X Return on

EquityOr g= Plough back Ratio x ROE

Arithmetic Mean RateCompound Annual Growth Rate

(CAGR)

Where x1, x2……. are the annual returns for the respective years.

It gives the smoothed annualized gain of an investment over a given time period.

CAGR is often used to describe the growth over a period of time of some element of the business.

CAGR dampens the effect of volatility of periodic returns that can render arithmetic means irrelevant.

V(t0) : start value, V(tn) : finish value, tn − t0 : number of years.

Actual or normalized values may be used for calculation as long as they retain the same mathematical proportion.

The CAGR can also be calculated as the geometric mean of the decimal multiplier equivalents of the individual period-over-period changes.

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An investor owns the share of Natural Waters Ltd., whose current cash dividend id Rs 3. The constant growth rate in dividend is 16 percent per year and the required rate of return is 20 percent. What is the value of the company’s share?

Single stage model only suitable for determining the value of stocks of an established company.

Model assumes that growth rate after n years remains constant and company after the initial abnormal growth settles to normal growth.

Abnormal growth stage

Constant (or normal) growth stage

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Determine the intrinsic value of an equity share, given the following data:

Last dividend (D0) = Rs 2Growth rate for the next five years: 15%Growth rate beyond 5 years: 10%Assume required rate of return be 12%. 

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We know that in order for an established company to grow, it has to have a positive growth potential. In other words, the following conditions must hold:•k > g •g – kb > 0 b(ROE)– kb > 0 ROE > k

P/E multiples for a share may be equated with projected growth rate in earnings. If PEG (P/E to growth ratio) is greater than one, then stock is overvalued. The basic problem with this rule of thumb is that it ignores the required rate by investor.

P/E multiple would be inverse of prime interest rate. It assumes that there is no relationship between prime interest rate and the level of corporate earnings. This assumption always does not hold good as the prime interest rate depends upon inflation rate, which also affects corporate earnings.

P/E multiple would be inverse of real rate of required by the investor. This rule protects the value of equity in face of inflation, i.e., equity income is suppose to rise in nominal terms in such a way that its real value is unimpaired.